The End of the Communist Dynasty

There is a cri­sis of con­fi­dence unfold­ing in Chi­na that is like­ly to end in a full scale cap­i­tal flight and a dis­or­der­ly col­lapse in both eco­nom­ic and polit­i­cal cohe­sive­ness. The low­er­ing of the reserve require­ments for Chi­nese banks, while report­ed in the media as a loos­en­ing of cred­it, is more like­ly an ear­ly sign of cap­i­tal flight. Sim­i­lar­ly reflec­tive of this, are the large increas­es of gold pur­chas­es by Chi­nese cit­i­zens who have few diver­si­fi­ca­tion options away from the RMB.

China’s wealth is con­cen­trat­ed abnor­mal­ly with­in an elite 1% of high net worth indi­vid­u­als. This 1% com­mand up to $5 USD tril­lion dol­lars in wealth. If these elite should rush the doors to move their wealth out of the coun­try using the mul­ti­tude of avenues that exist to evade Chi­nese cap­i­tal con­trols, then the Chi­nese banks may face the biggest bank run in his­to­ry.

The prob­lem is that while the pro­pa­gan­da machine might con­trol the minds of the mass­es, the wealthy elite are vir­tu­al­ly immune to thought con­trol and are like­ly to be the best informed and have the means to be the first to leave. Reserves are most­ly tied up in USD and trea­suries can­not be liq­ui­dat­ed for fear of rais­ing the val­ue of the RMB. Along with fur­ther erod­ing trade sur­plus­es, this means a cap­i­tal flight by the elite occur­ring with mas­sive insol­ven­cy in the cred­it mar­ket could vapor­ize the Chi­nese liq­uid­i­ty in what will seem like an eco­nom­ic Cat 5 hur­ri­cane.

The Chi­nese econ­o­my is in the final stages of largest Ponzi scheme ever devised. Min­sky out­lined three dis­tinct phas­es in the cred­it cycle: In the first phase known as the hedge phase; eco­nom­ic actors bor­row mon­ey to invest in order to cre­ate goods to sell for prof­it. In the sec­ond stage, the spec­u­la­tive phase, more eco­nom­ic actors join the econ­o­my, bor­row­ing mon­ey to invest in assets in the expec­ta­tion that these assets will rise in val­ue. In the last stage, known as the Ponzi stage, eco­nom­ic actors bor­row in the hope that con­di­tions will improve. This bor­row­ing is designed to avoid insol­ven­cy dur­ing what is per­ceived or hoped to be a short to medi­um term set­back in eco­nom­ic con­di­tions.

Some may argue that the Min­sky mar­ket dri­ven insta­bil­i­ty hypoth­e­sis is not suit­ed to Chi­na and that they are chiefly a cen­tral­ly planned state con­trolled econ­o­my. This reflects a fun­da­men­tal mis­un­der­stand­ing of Minsky’s work. The West­ern economies’ attempt to cen­tral­ly plan eco­nom­ic activ­i­ties from the con­sump­tion end, the state based cap­i­tal­ism that Chi­na has become known for attempts to cen­tral­ly con­trol the econ­o­my from the pro­duc­tion side.

The Chi­nese pro­duc­tion econ­o­my can­not be seen in iso­la­tion from the con­sump­tion economies of the West; debt based con­sump­tion pro­vid­ed the umbrel­la under which the Chi­nese mir­a­cle grew. When the GFC col­lapsed West­ern debt based con­sump­tion react­ed by pro­vid­ing the last line of Min­sky Ponzi financ­ing via gov­ern­ment bail-outs. Gov­ern­ments faced with bank­ing col­lapse chose keep the sys­tem going by trans­fer­ring debt from pri­vate hands to those of the tax­pay­ers.

The Chi­nese, faced with a mas­sive col­lapse in export income, chose to keep the econ­o­my func­tion­ing by stim­u­lat­ing the econ­o­my with mas­sive cap­i­tal works and lend­ing. In both cas­es the gov­ern­ment was the provider of the last line Ponzi financ­ing to keep the econ­o­my rolling. Now that this Ponzi financ­ing has been near exhaust­ed in both the West and the East, pro­found col­lapse is the only log­i­cal out­come.

Where­as the Min­sky moment in West­ern economies comes by way of over-enthu­si­as­tic pri­vate bor­row­ers, the insta­bil­i­ty in Chi­na is poten­tial­ly more vir­u­lent in that its source is an over-enthu­si­as­tic gov­ern­ment: the for­mer rely­ing on the sol­ven­cy of bor­row­ers and the lat­er rely­ing on the sol­ven­cy of the state. Some argue that while the Chi­nese state remains sol­vent, no mat­ter how many emp­ty build­ings exist they can con­tin­ue the game. The ques­tion then is — Are they sol­vent and how long can they remain that way? The expo­nen­tial growth in Chi­nese debt and mal-invest­ment and the very unlike­ly return of West­ern demand means the sys­tem will become insol­vent in the short to medi­um term.

The num­ber of investors who have suf­fered loss­es due to wide­spread fraud is grow­ing expo­nen­tial­ly and the list of those that have racked up sub­stan­tial loss­es includes some of the lead­ing investors in the world. This list of investors includes invest­ment leg­ends like Antho­ny Bolton one of Europe’s most well-known fund man­agers, leg­endary invest­ment icon John Paul­son have been the vic­tims of fraud, the scale of which has nev­er been seen in eco­nom­ic his­to­ry.

Bolton wasn’t the only one. The leg­endary investor John Paul­son is being sued by his investors after los­ing $462M of his 23B fund invest­ing in Sino For­est Paul­son Fund Sued Over Sino-For­est Loss­es. The Sino For­est deba­cle was kicked off with a 19 page report issued by Car­son Block of Mud­dy Water Sino For­est Report. This report didn’t mince words and came out form the start com­par­ing the com­pa­ny to Bernie Madoff’s Ponzi scheme.

“Like Mad­off, TRE is one of the rare frauds that is com­mit­ted by an estab­lished insti­tu­tion. In TRE’s case, its ear­ly start as an RTO fraud, luck, and deft nav­i­ga­tion enabled it to grow into an insti­tu­tion whose “qual­i­ty man­age­ment” con­sis­tent­ly deliv­ered on earn­ings growth.”

The prob­lem with Sino For­est was that most of the forests the com­pa­ny claimed as assets sim­ply didn’t exist. Rather than being a few iso­lat­ed cas­es, these exam­ples sig­nal an epi­dem­ic of sys­temic fraud and cor­rup­tion that per­vades entire Chi­nese econ­o­my. This sys­temic fraud direct­ly cor­re­lates to Minsky’s final Ponzi phase: cheap cred­it, floods the econ­o­my, even­tu­al­ly exhaust­ing use­ful ways it can be uti­lized. This, togeth­er with the lack of sys­temic con­trols that accom­pa­ny cheap cred­it, ini­tial­ly caus­es mal-invest­ment into projects that will nev­er return enough to ser­vice their debt. Then, hav­ing exhaust­ed all rea­son­able avenues of mal-invest­ment, large amounts get siphoned into the hands of crim­i­nal oppor­tunis­tic eco­nom­ic agents who game the sys­tem.

What is China’s response to this plague of fraud in Chi­nese US list­ed stocks? They intend to make it very dif­fi­cult for the Big 4 to con­tin­ue to work in Chi­na ‘Big Four’ audi­tors brace for big changes in Chi­na. In the case of Long­top Finan­cial, Deloites, the firms’ audi­tors have been unable to pro­vide the SEC with any doc­u­men­ta­tion about the col­lapse for fear of break­ing China’s state secre­cy laws.

These frauds are extreme­ly sophis­ti­cat­ed and have gone unde­tect­ed by the large audit firms. They are not just the result of a series of inde­pen­dent events under­tak­en by sim­i­lar­ly dis­hon­est busi­ness peo­ple act­ing alone. Rather, a recent report sug­gests they are part of a sys­temic net­work of agents act­ing inside and out­side of Chi­na whose main pur­pose is to per­pet­u­ate invest­ment fraud on a scale nev­er seen before in eco­nom­ic his­to­ry.

One of the cen­tral play­ers in uncov­er­ing Chi­nese invest­ment fraud research is the firm Mud­dy Waters who recent­ly pub­lished a white paper enti­tled Fraud­u­ca­tion Part I: in this paper the author out­lines how Chi­nese busi­ness­men are taught and spon­sored by experts, who spon­sor and coach fraud­sters in sub­jects like fal­si­fy­ing records, account­ing, assets and the var­i­ous meth­ods need­ed to pull off grand frauds. When a char­ac­ter like John Paul­son gets tak­en for near­ly half a bil­lion there is a lot of moti­va­tion on the crim­i­nal side to get things right

The fraud school’s assis­tance went well beyond pro­vid­ing doc­u­ment and account­ing tem­plates. The fraud school pro­vid­ed a net­work of “friend­ly” audi­tors that would help the com­pa­nies get through the ini­tial due dili­gence process­es. The fraud school also helped com­pa­nies game the due dili­gence process by pro­vid­ing the com­pa­nies with con­tact infor­ma­tion of sup­pli­ers and cus­tomers to give to poten­tial investors. The

sup­pli­ers and cus­tomers were frauds – the school hired them mere­ly to play a role and answer ques­tions accord­ing to the script. (Source: Mud­dy Waters)

Fraud is cen­tral to the Chi­nese sys­tem, it has emerged via vir­u­lent muta­tion of the ancient trib­ute sys­tem. In the past, these trib­ute sys­tems reflect­ed an ancient form of pri­vate reg­u­la­to­ry order. In the past there was often a lim­it­ed basis for the rule of law to gov­ern trans­ac­tions. Through­out Chi­nese his­to­ry, trade relied on sys­tems of trib­ute to ensure secure busi­ness and polit­i­cal out­comes.

These old sys­tems were still essen­tial through­out Asia up until only a few decades ago because, trans­act­ing par­ties could not rely on the rule of law to ensure the secu­ri­ty of terms gov­ern­ing a trans­ac­tion. In Chi­na this has evolved into gov­ern­ment spon­sored sys­temic cor­rup­tion with West­ern moti­va­tions of greed and crim­i­nal­i­ty. It infects every lev­el of the pri­vate and pub­lic sec­tor.

A small piece of it was exposed recent­ly in the “Bo” scan­dal, where there are reports of it infect­ing the fam­i­lies: Not only the Bo Lai fam­i­ly but even to the high­est lev­el of gov­ern­ment- up to and includ­ing the fam­i­ly of Pro­pa­gan­da Min­is­ter, Liu Yun­shan .Who 16 elder retired elder states­men peti­tioned to have sacked

Rather than being seen as iso­lat­ed inci­dents, these exam­ples reflect a cul­tur­al meme, a way of doing busi­ness that rep­re­sents the stan­dard oper­at­ing pro­ce­dure for a large seg­ment (if not all) of the Chi­nese econ­o­my.

The epi­dem­ic of fraud sits like a struc­tur­al ele­ment across both the pri­vate and gov­ern­ment sec­tor fur­ther mag­ni­fy­ing the mal-invest­ment caused by the mas­sive cred­it expan­sion. For exam­ple: The high speed rail project audits reveal mil­lions have been siphoned toward cor­rupt con­trac­tors and gov­ern­ment offi­cials. This amount mere­ly rep­re­sents the siphon­ing on the core bud­get and doesn’t reflect the extra costs loaded by each of the con­trac­tors.

Take for exam­ple Hollysys, the provider of sig­nalling and con­trol sys­tems for many the Chi­nese high speed train projects. This com­pa­ny man­aged to earn ‘154M (2009)-175M(2010) with a tri­fling $3.1 M in cap­i­tal equip­ment. Their expla­na­tion for this is they out­source all man­u­fac­tur­ing, which is a lit­tle odd since they have such mas­sive build­ings, cov­er­ing hun­dreds of acres and $24M in inven­to­ries.

Chi­na is a coun­try that is essen­tial­ly a direct­ly fund­ed fiat sys­tem, where­as in a tra­di­tion­al fiat fund­ed sys­tem the state prints mon­ey to direct­ly pur­chase goods and ser­vices. Here, the Chi­nese sys­tem achieves the same out­come by lend­ing with lit­tle prospect of repay­ment. A sys­tem that per­pet­u­al­ly rolls over debts does not con­sti­tute a cred­it based mon­ey sys­tem. Whether they are cor­po­ra­tions or indi­vid­u­als, many of state affil­i­at­ed eco­nom­ic agents sim­ply can­not default because the lender is unwill­ing to fore­close on an influ­en­tial polit­i­cal play­er. If you can­not pay you can sim­ply ring the par­ty to arrange a rollover the bal­ance.

The funds are effec­tive­ly fis­cal stim­u­lus car­ried out gov­ern­ment-con­trolled inter­me­di­aries, state and local gov­ern­ments, who then spend these funds on projects dreamt up by cor­rupt local politi­cians. These projects are built with bor­rowed mon­ey by var­i­ous state aligned eco­nom­ic agents. These agents have lit­tle hope of repay­ing the debts incurred. This in turn means that the debts are roll over when they fall due. In real­i­ty the State is sim­ply print­ing mon­ey, spend­ing it and then at some point writ­ing it off. This is being done at a speed and scale nev­er before seen in human his­to­ry.

Jim Chanos the famous hedge fund investor who fore­saw the sub­prime cri­sis described the entire Chi­nese econ­o­my as “1000 times worse than Dubai”. In 2008, when the world expe­ri­enced the GFC, Chi­na dou­bled down and sim­ply spent their way through via mas­sive cred­it stim­u­lus. When China’s mas­sive export mar­kets shrank due to the West­ern debt cri­sis the Chi­nese elect­ed to con­vert their econ­o­my from an export based one to a con­struc­tion based econ­o­my. Mean­while, the West­ern media per­pet­u­ates the myths of China’s sup­posed ascent to dis­place the US as being the world largest econ­o­my.

The prob­lem is that the West­ern economies nev­er recov­ered and the Chi­nese have had to con­tin­ue their mas­sive growth pure­ly based on con­struct­ing roads, bridges, air­ports, dams and var­i­ous oth­er con­struc­tion based infra­struc­ture

If one starts with the offi­cial eco­nom­ic sta­tis­tics and works down through the account­ing, tax­a­tion, bank­ing sys­tems and then across Chi­nese indus­try, there is ram­pant fraud, poor report­ing and out­right pro­pa­gan­da at every lev­el. The Chi­nese econ­o­my is large­ly a cen­tral gov­ern­ment bud­getary sys­tem of fis­cal spend­ing; each local gov­ern­ment sub­mits spend­ing plans to cen­tral par­ty author­i­ties, who in turn rec­om­mend expen­di­ture up the line.

In 2008 in order to counter the shock of the GFC the Chi­nese Com­mu­nist Par­ty (CCP) engaged in mas­sive stim­u­lus pro­grams just as the West did. The dif­fer­ence though was in the way the stim­u­lus was deliv­ered. In Aus­tralia, stim­u­lus was deliv­ered as gov­ern­ment spend­ing. This is tra­di­tion­al­ly known as fis­cal stim­u­lus where the gov­ern­ment bor­rows mon­ey to spend on projects like the new fibre optic NBN Net­work. In Chi­na, though the stim­u­lus was deliv­ered much less tra­di­tion­al­ly; the increase in expen­di­ture was deliv­ered through banks who were encour­aged to offer mas­sive amounts of debt to provin­cial gov­ern­ments, state owned and spon­sored owned enter­prise.

The impe­tus for the stim­u­lus might have been cen­tral­ly planned, but the spend­ing was decen­tralised. Provin­cial gov­ern­ments in Chi­na are not able to issue bonds, so state owned invest­ment vehi­cles bor­row the mon­ey, often using state gift­ed real estate col­lat­er­al as secu­ri­ty. The real­i­ty is that the major­i­ty of these invest­ments, do not or will not pay a return any­where near that required to make debt repay­ments. These projects born of cor­rup­tion, nursed by self-serv­ing bureau­cra­cy fail to thrive due to the defec­tive finan­cial DNA.

Provin­cial cred­it expand­ed at a rate of +35% of GDP per annum and many of the loans need­ing to be rolled over, with no prospect of ser­vice­abil­i­ty. For this luna­cy to con­tin­ue, what is pri­mar­i­ly a con­struc­tion econ­o­my must build more infra­struc­ture this year than last and more again next year and the year after into per­pe­tu­ity. If these projects had no chance of becom­ing sol­vent going con­cerns in the past, then new projects are even less like­ly to repay their lenders in the future. In this envi­ron­ment of man­ic over­pro­duc­tion, elite cap­i­tal at some point will pan­ic and run for the exits.

To a large extent the Chi­nese pro­pa­gan­da machine has cap­tured an unques­tion­ing West­ern media;, the meme that Chi­na is the next ris­ing super pow­er and will short­ly over­take the US is a part of this pro­pa­gan­da sto­ry. West­ern­ers imbue their view of Chi­na’s future with cul­tur­al qual­i­ties that have sim­ply nev­er been reflect­ed in his­tor­i­cal fact. In fact, pro­grams like the one child pol­i­cy reflect the oppo­site

If the projects in 2009 and 2010 can­not pay ade­quate returns to ser­vice debt then what hope do the new projects have? Fur­ther­more, due to the epi­dem­ic of cor­rup­tion through­out China’s pub­lic and pri­vate sec­tor, the projects rarely reflect good val­ue for mon­ey. This places the entire Chi­nese econ­o­my in Minsky’s last phase of expan­sion: The Ponzi phase, where lend­ing is per­pe­trat­ed in the hope that con­di­tions will improve and with lit­tle hope of repay­ment.

In the West debt is to be freely giv­en but even at its worst it is done on some basis of return. When an eco­nom­ic sys­tem los­es its way, to the extent Chi­na has done, the ten­sion it cre­ates on a soci­ety becomes unbear­able. When the even­tu­al day of reck­on­ing comes and the abil­i­ty to expand debt is exhaust­ed, then the physics of com­plete col­lapse come into play.

A bleak harsh real­i­ty will descend on a polit­i­cal sys­tem that’s run out of options. One unique fea­ture will come the fore: That Chi­na unique­ly spends more on inter­nal secu­ri­ty than exter­nal defence. Chi­na will at once face a great leap back­ward forc­ing a mil­i­tary coup and the effec­tive end of CCP rule. Whether the mil­i­tary can hold the coun­try togeth­er through a Sovi­et style col­lapse is anyone’s guess. One out­come could see the wealth­i­er provinces seek­ing inde­pen­dence, how­ev­er it ends it will be the end of a dynasty that start­ed with Mao.

Chi­na will not be be the world’s biggest econ­o­my this cen­tu­ry. It will fal­ter, due to its demo­graph­ic arthri­tis and debt explo­sion. The denoue­ment of its cor­rup­tion will pull it down like no oth­er col­lapse in his­to­ry. Chi­na will short­ly have “inter­est­ing times.”

Craig Tin­dale is the Vice Pres­i­dent of the Cen­tre for Eco­nom­ic Sta­bil­i­ty, Pro­fes­sor Steve Keen’s non-prof­it research ini­tia­tive.

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.

Video overview

Debunking Economics II

Disclaimer

This site does not give personal financial advice. The focus of this blog is economic analysis, and how you interpret this with respect to your own financial decisions is entirely up to you.

Steve Keen, Debtwatch, and any employees or associates will not be held liable for any losses resulting from decisions taken by any individual or entity as a consequence of reading materials on this blog.

Membership or sponsorship of this blog does not constitute purchasing any product service apart from those listed in the membership and sponsorship conditions.